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The Financial Crisis
of 2008 Simplified
By: Economyria
Introduction
• What is a financial crisis?
• A financial crisis is a crisis which critically affects the
functioning of th...
Immediate Trigger of the
financial crisis of 2008
• Burst of the Housing bubble:
• A bubble is when the price of an asset ...
Housing Prices in the USA
What caused the bubble/
housing price rise?
1. Low interest rates
• During the period from 2000 to 2003, Federal Reserve l...
What caused the bubble?
2. Global saving glut:
• There was surplus savings in China, Japan & the middle-eastern
oil export...
What caused the bubble?
3. Government policies to provide housing to all
• To provide housing to all, Government introduce...
What caused the bubble?
4. The Great Moderation (1980s to 2007):
• Economy stable
• It was period of low inflation and sta...
Consequences of the Housing
Bubble
• It led to decline in mortgage/ loan standards
• Financial institutions (banks) began ...
Consequences of the Housing
Bubble
• The standard mortgage in the US has a maturity of 30 years with a
fixed interest rate...
The Burst of the Housing
Bubble
• By September 2007 prices declined by 25 % due
to the following reasons:
1. Decline in de...
Housing Bubble burst
2. Fed started increasing the interest rates from 1
% to 5.25 % (June 2004 to June 2006).
• People no...
Consequences of the
Housing Bubble Burst
• As the housing bubble burst, people began to default on their
home mortgage loa...
Consequences of the
Housing Bubble Burst
• It resulted in Foreclosure. Foreclosure means the banks
started selling off the...
How a housing crisis became a
financial crisis?
• The bubble could have been restricted to the
housing market. But, it spr...
How a housing crisis became a
financial crisis?
3. Poor risk management by the financial
institutions.
4. Lack of adequate...
Use of complex financial
instruments
1. Mortgage backed Securities
• Home mortgage loans are assets for the banks.
In retu...
Use of complex financial
instruments
• Banks are the originators of the loans
• The financial institutions who buy these
m...
Use of complex financial
instruments
• They cut this homogeneous pool into tranches (parts/
slices)
• Then they issue secu...
Mortgage Backed Security
Use of complex financial
instruments
• These securities can be traded like shares
• This process is called securitisation
...
Use of complex financial
instruments
• Investors in MBS include pension funds, insurance companies,
foreign banks and weal...
Use of complex financial
instruments
2. Collateral Debt obligations
• Similar to MBS
• All debts like auto loan, credit ca...
Use of complex financial
instruments
• A mortgage backed security investor can buy CDS to insure it
against losses.
• The ...
Use of complex financial
instruments
• Investors and FIs around the world invested in MBS and CDOs
and bought CDS.
• Value...
Use of Short term Funding or
commercial paper
• Commercial paper is a security that is issued by large
companies to meet t...
Use of Short term Funding or
commercial paper
• Lehman Brothers was an Investment bank which invested
in MBS
• As MBS suff...
Poor risk management by the
financial institutions
• Risk was spread throughout the system
• Because of complexity of the ...
Poor risk management by the
financial institutions
• Runs began as financial firms and investors pulled
funding from any f...
Lack of Regulations
• Rise of Shadow banking system.
• Investment banks (like Lehman brother and bear sterns) and
Hedge fu...
Lack of Regulations
• Run on the shadow banking system.
• Shadow banking system also means unregulated activities by
regul...
Not concerned about the
stability of the FS as a whole
• Individual regulators for different agencies
• Increased financia...
Not concerned about the
stability of the FS as a whole
• There was a breakdown of trust in the entire
financial system.
• ...
The Crisis
• Credit crunch. Credit market dried up.
• Huge pressures on key financial firms Bear
Sterns, Fannie & Freddie ...
The Crisis
• Threatened the collapse of the entire financial institutions
• Bail-out to prevent the failure of systemicall...
The Aftermath
• It led to a world-wide recession with high unemployment
rate. Economy slowed 7 % in the first quarter of 2...
The Aftermath
• Decline in credit availability
• No investors confidence
The Aftermath
• Governments responded with fiscal stimulus,
monetary policy expansion (Quantitative Easing)
• Institutiona...
The Aftermath
• Quantitative easing is an unconventional
monetary policy tool which was used by the
Central bank of the US...
The Aftermath
• In quantitative easing, Federal reserve bank
buys Government bonds and other financial
assets from commerc...
Thank you
•Check out our blog Economyria:
http://economyria.com/
•You can subscribe to our posts by
email by clicking on the followi...
About the Author
• Alumnus of Shri Ram College of Commerce
and Delhi School of Economics
• Currently working as an Assista...
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The financial crisis of 2008 simplified

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The financial crisis of 2008 simplified

  1. 1. The Financial Crisis of 2008 Simplified By: Economyria
  2. 2. Introduction • What is a financial crisis? • A financial crisis is a crisis which critically affects the functioning of the financial system • Financial system includes banks, mutual funds, investment banks etc. • In a financial crisis, the financial assets (like shares) lose its nominal value
  3. 3. Immediate Trigger of the financial crisis of 2008 • Burst of the Housing bubble: • A bubble is when the price of an asset increases above their legitimate intrinsic worth. • In a bubble, the price of the asset does not correspond to its fundamental value. (eg- the fundamental value/ intrinsic worth of pen is Rs 20. But, price rises to above 1000.) • From the 1990s until February 2007, prices of houses in the US increased by a staggering 130 %. (Housing Bubble) • This bubble eventually had to burst
  4. 4. Housing Prices in the USA
  5. 5. What caused the bubble/ housing price rise? 1. Low interest rates • During the period from 2000 to 2003, Federal Reserve lowered interest rates from 6.5 % to 1 %. • It was done to combat the negative impact of the the Dot-com bubble burst (2000)and the Sept 2001 attack at the WTC. • People began to take more loans (home mortgage loans) to buy homes. Demand for houses increased
  6. 6. What caused the bubble? 2. Global saving glut: • There was surplus savings in China, Japan & the middle-eastern oil exporting countries. • It flowed into the US economy (safe investment) • It kept interest rates in the United States low • They invested in the housing market as well through complex financial assets
  7. 7. What caused the bubble? 3. Government policies to provide housing to all • To provide housing to all, Government introduced policies to encourage people to take more home loans • One of the policy was that no income tax will have to be paid on the interest paid on home mortgages/ loans
  8. 8. What caused the bubble? 4. The Great Moderation (1980s to 2007): • Economy stable • It was period of low inflation and stable growth. • Willing to take up more risks than ever. • Households (and financial institutions) became highly leveraged (took more loans)
  9. 9. Consequences of the Housing Bubble • It led to decline in mortgage/ loan standards • Financial institutions (banks) began to lend to sub-prime borrowers (people with low-credit worthiness) • It brought more people into the housing market and price increased further • Began to use a different type of mortgage called Adjustable rate mortgage
  10. 10. Consequences of the Housing Bubble • The standard mortgage in the US has a maturity of 30 years with a fixed interest rates • But, Banks began to give out loans with adjustable/ flexible interest rates • The initial interest rates were too low (1 %) and after 2 or 3 years, the interest rates reflects the market interest rates. (teaser loans) • After 2 or 3 years, refinance into a standard mortgage. • Refinance means taking new loan to repay an existing loan
  11. 11. The Burst of the Housing Bubble • By September 2007 prices declined by 25 % due to the following reasons: 1. Decline in demand for houses • Housing market became saturated and hence there was a decline in demand of the houses in spite of the easy home loans.
  12. 12. Housing Bubble burst 2. Fed started increasing the interest rates from 1 % to 5.25 % (June 2004 to June 2006). • People no longer had access to cheap home loans • Demand for houses decreased • Hence, prices declined
  13. 13. Consequences of the Housing Bubble Burst • As the housing bubble burst, people began to default on their home mortgage loans • Adjustable Rate Mortgage holders could not refinance. • They also defaulted on the loans
  14. 14. Consequences of the Housing Bubble Burst • It resulted in Foreclosure. Foreclosure means the banks started selling off the collateral (houses) to recover their loan • But, as house price low, banks could not recover their loans and suffered losses. • This was essentially called a sub-prime mortgage crisis
  15. 15. How a housing crisis became a financial crisis? • The bubble could have been restricted to the housing market. But, it spread to whole of the financial markets due to the following reasons: 1. Use of complex financial instruments 2. Use of commercial papers
  16. 16. How a housing crisis became a financial crisis? 3. Poor risk management by the financial institutions. 4. Lack of adequate regulations 5. The regulators were not concerned about the financial system as a whole
  17. 17. Use of complex financial instruments 1. Mortgage backed Securities • Home mortgage loans are assets for the banks. In return for these loans they get monthly interest payments and the principal • They sell these assets to other financial institutions.
  18. 18. Use of complex financial instruments • Banks are the originators of the loans • The financial institutions who buy these mortgages aggregate the mortgages into homogeneous pool. • Pooling is done to reduce and diversify risk.
  19. 19. Use of complex financial instruments • They cut this homogeneous pool into tranches (parts/ slices) • Then they issue securities backed on these assets. • These securities are called mortgage backed securities • If an investor buys these securities, they receive proportionate share of principal and interest
  20. 20. Mortgage Backed Security
  21. 21. Use of complex financial instruments • These securities can be traded like shares • This process is called securitisation • The pioneers of this process were the private corporations established by the Government. (Fannie Mae, Freddie Mac). • They served as an intermediary between the originators and the ultimate holder of the mortgage
  22. 22. Use of complex financial instruments • Investors in MBS include pension funds, insurance companies, foreign banks and wealthy individuals. • It is also retained by the financial institutions in their own account • MBS became a popular investment option as the interest rates in US were very low. • To comprehend the seriousness of the situation, Fannie and Freddie owed nearly $5 trillion to investors in mortgage obligations.
  23. 23. Use of complex financial instruments 2. Collateral Debt obligations • Similar to MBS • All debts like auto loan, credit card debt, education loan etc. are pooled together and securities are issued backed on these assets 3. Credit Default Swap: • It is an insurance instrument.
  24. 24. Use of complex financial instruments • A mortgage backed security investor can buy CDS to insure it against losses. • The USA’s largest insurance company called AIG issued CDS in return for a premium. • Came under a lot of pressure after the bubble burst as AIG could not make good the losses incurred by the MBS holders
  25. 25. Use of complex financial instruments • Investors and FIs around the world invested in MBS and CDOs and bought CDS. • Value of these securities tied to housing prices declined • Therefore, the crisis could not be restricted to the housing market in the US • It spread to other parts of the financial institution and it became a global crisis
  26. 26. Use of Short term Funding or commercial paper • Commercial paper is a security that is issued by large companies to meet their short term funding requirements • It has a maturity period of less than 3 months and traded in money market funds • As it is a short term funding instrument it is vulnerable to runs. • The collapse of Lehman brothers was a direct consequence of using commercial papers for funding
  27. 27. Use of Short term Funding or commercial paper • Lehman Brothers was an Investment bank which invested in MBS • As MBS suffered losses, Lehman Brothers could not roll- over its debt. • It defaulted on its Commercial Papers • Lehman brothers’ default led to the failure of the oldest money market fund.
  28. 28. Poor risk management by the financial institutions • Risk was spread throughout the system • Because of complexity of the financial instruments, financial institutions were not sure about their risks. • There was uncertainty in the financial system and people found it difficult to figure out which institution is actually exposed to the housing market.
  29. 29. Poor risk management by the financial institutions • Runs began as financial firms and investors pulled funding from any firm thought to be vulnerable to losses. • Maturity mismatch. • Banks lost confidence in each other.
  30. 30. Lack of Regulations • Rise of Shadow banking system. • Investment banks (like Lehman brother and bear sterns) and Hedge funds did not have same regulatory requirements as commercial banks. • As important as Commercial Banks in lending. • No financial cushion to absorb losses. (increased leverage)
  31. 31. Lack of Regulations • Run on the shadow banking system. • Shadow banking system also means unregulated activities by regulated institutions. • Financial institutions used off-balance sheet vehicles, example- loans were shown as assets in the books but after it was sold off not mentioned in the books. . • Credit rating agencies: AAA ratings
  32. 32. Not concerned about the stability of the FS as a whole • Individual regulators for different agencies • Increased financialisation: (debt > equity) and financial markets dominate the real economy • The above factors interacted with each other and caused the financial sector to become increasingly fragile. It was a systemic crisis.
  33. 33. Not concerned about the stability of the FS as a whole • There was a breakdown of trust in the entire financial system. • Nobody was willing to lend to each other. • There was an extreme credit crunch and it affected other sectors of the economy which were heavily dependent on credit.
  34. 34. The Crisis • Credit crunch. Credit market dried up. • Huge pressures on key financial firms Bear Sterns, Fannie & Freddie Mac, Lehman Brothers, Merill Lynch, AIG etc • Interconnected financial market.
  35. 35. The Crisis • Threatened the collapse of the entire financial institutions • Bail-out to prevent the failure of systemically important financial institutions (SIFI) or Too Big To Fail • Housing crisis- MBS lost value- Investment banks- MMF- Insurance company • To big to fail means failure disastrous to the greater economic system.
  36. 36. The Aftermath • It led to a world-wide recession with high unemployment rate. Economy slowed 7 % in the first quarter of 2008 recession. • Stock markets tumbled. • Euro-zone debt crisis: Portugal, Ireland, Greece, Spain, Cyprus. Incurred a lot of debt to bail-out financial institutions. Read about the Greece Crisis in this article (http://economyria.com/the-greece-debt-crisis-explained/)
  37. 37. The Aftermath • Decline in credit availability • No investors confidence
  38. 38. The Aftermath • Governments responded with fiscal stimulus, monetary policy expansion (Quantitative Easing) • Institutional bailouts (financial support) • Basel III capital and liquidity standards adopted by countries worldwide: international banking standards. Increased CAR. To 11.5 % from 9%)
  39. 39. The Aftermath • Quantitative easing is an unconventional monetary policy tool which was used by the Central bank of the USA (Federal reserve) • The federal reserve had to resort to quantitative easing because the conventional monetary policy tools had become
  40. 40. The Aftermath • In quantitative easing, Federal reserve bank buys Government bonds and other financial assets from commercial banks to inject cash into the economy. Read this article to know in detail http://economyria.com/quantitative- easing-demystified/)
  41. 41. Thank you
  42. 42. •Check out our blog Economyria: http://economyria.com/ •You can subscribe to our posts by email by clicking on the following link: •https://feedburner.google.com/fb/a/ mailverify?uri=Economyria&amp%3Bl oc=en_US
  43. 43. About the Author • Alumnus of Shri Ram College of Commerce and Delhi School of Economics • Currently working as an Assistant Professor • Founder of the blog: Economyria (http://economyria.com/)

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